Better Buy: Merck or Bristol-Myers?

If Merck's (MRK 0.92%) MK-3475 drug for advanced melanoma can wind its way through trials and win FDA approval, it will face-off with Bristol-Myers' (BMY 0.43%) fast-growing drug Yervoy, which is on pace to reach $1 billion blockbuster status next year.  

The melanoma market was worth $2.4 billion in the United States in 2010, and it's expected to grow further as new, more expensive treatments help more patients. Does that trend make Merck a better buy than Bristol?  

Debating earnings
The ability to translate sales into fatter profit fuels acquisitions, research and development, dividend payments, and share buybacks. That's especially important to these two companies, given that each is navigating stiff headwinds from high-profile patent expirations. Merck lost protection for its $5 billion-a-year blockbuster drug Singulair, and Bristol lost protection for its blockbuster drug Plavix last year.

To offset falling sales, each company is cutting costs to improve margin. Merck announced plans in October to reduce its employee count by 20% in a bid to shave $2.5 billion in expenses. Bristol announced in November that it was letting 75 people go from its R&D team as it shutters work in three disease areas to focus on late-stage oncology and immunotherapy programs.

Those moves will likely help Merck and Bristol capture bigger profits once new drugs come to market, including Merck's MK-3475 and Bristol's daclatisvir, which has been filed for approval as a treatment for hepatitis C in Japan.

Bristol, with historical operating margin near 30%, has been better than Merck at converting sales into profit. The two swapped places earlier this year as Bristol struggled following the Plavix expiration.  However, Bristol's margin moved back above Merck's in the third quarter.

MRK Operating Margin (TTM) data by YCharts

Bristol's third-quarter pop in margin appears to have caught analysts flat-footed, allowing Bristol to outpace their forecast by 4.5%. Merck beat analysts by a similar amount, it's 4th consecutive quarter of over-delivering earnings.

Source: Yahoo! Finance

Despite Merck and Bristol's solid bottom-line performance this year, analysts remain pessimistic about 2014. The Street has cut its earnings outlook for Merck from $3.68 per share to $3.49 over the past 90 days. And they've lowered forecasts for Bristol from $2.01 to $1.94.

Those cuts are likely driven by worries over another wave of patent expirations, which include Merck's oncology drug Temodar.   That drug had $900 million in sales last year. Bristol's Baraclude, used to treat hepatitis B, raked in $1.4 billion in sales during 2012, of which $241 million came from sales in the United States.  Those U.S. sales could face generic competition soon, following the invalidation of Baraclude's patent this past February.

Source: Yahoo! Finance. All figures for December of their respective calendar years.

Debating valuation

Investors' appetite for Merck and Bristol is big, with the price-to-sales ratio for both hitting or nearing five-year highs. That suggests growth from fast-growing drugs like Bristol's Yervoy and up-and-coming drugs such as Merck's MK-3475 is already being priced in.

MRK PS Ratio (TTM) data by YCharts

If we consider price-to-earnings ratios, investors are more willing to pay up for Bristol's future earnings than they are Merck's. Bristol is trading at 26 times next year's estimates, handily above the 16.7 average levels it's traded at over the past five years. Merck investors are a bit more sanguine. They're paying just 14 times future earnings -- far less than they've paid over the past five years.

Source: Yahoo! Finance

Yet when we consider P/E to growth ratios, or PEG, which measures price to earnings and expected future growth, we see Bristol, with a PEG ratio of just 0.63, appears more reasonably priced than Merck. That said, investors have never been willing to overpay for growth at these two companies, which is evidenced by low PEG ratios over the past five years.

MRK PEG Ratio (Forward) data by YCharts

Valuing future earnings

When it comes to mature businesses like big pharmaceutical companies, investors tend to pay a range for earnings over time. It's rare to see mature companies like these two reinvent themselves so completely that they merit a new long-term multiple.

That suggests trailing P/E ratios are more likely to move back to long-term averages than remain at lofty levels. If we assume that will prove true in the case at Merck, it's more likely we'll see a price closer to 15 or 16 times earnings than 30 times. At Bristol, it's more likely P/E ratios will drop back into the teens too.

If that happens, then Bristol's shares appear overvalued based on next year's earnings, while Merck's appear undervalued by 11%. Of course, those assumptions may prove wrong, and could vary widely based on how well these two execute on late stage trials. But they give you a good starting point for determining how expensive or cheap the two companies may be.

Source:  Yahoo! Finance

The Fool's final take

A lot of excitement surrounds Bristol, thanks to its melanoma drug Yervoy and its $110,000 price tag. Yervoy generated $238 million for Bristol in the third quarter, up 33% from last year. But if Bristol is going to justify its somewhat lofty valuation, it's going to need to leverage those planned cost cuts against wins from promising drugs including daclatisvir and nivolumab, a drug with 25 oncology trials under way.

Over at Merck, investors may be underestimating the company's potential to right the ship in the wake of lower sales tied to patent expiration. But that undervaluation exists only If Merck can hit its goal on cost cuts, and succeed in bringing MK-3475 and other new drugs to market.